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APPLIED STATISTICS
Demand analysis
Renu Kaul and Sanjoy Roy Chowdhury
Reader, Department of Statistics,
Lady Shri Ram College for Women
Lajpat Nagar, New Delhi – 110024
4-Jan-2007 (Revised 20-Nov-2007)
CONTENTS
Theory and analysis of consumer’s demand
Law of demand
Law of supply
Price elasticity of demand
Demand curve of constant elasticity
Estimation of demand curves
Pigon’s Method
Engel’s Curves
Estimation of the demand curve from market statistics
Forms of the demand functions
Income elasticity of demand
Keywords
Demand and supply; Elasticity of demand; Demand curve; Engel’s curves; Pigon’s method, Leontief’s method
Theory and analysis of consumer’s demand
By demand for a commodity we mean the desire to have it at a given price, i.e. the desire to
have a commodity should be accepted by the capacity as well as willingness to pay for it.
Demand for a commodity depends on a number of factors such as its price, income, price of
other commodities, time etc. In demand analysis we study the relationship between market
price and quantity demanded for a commodity at that price on the basis of time series data,
keeping other factors constant. We also study the change in demand as a result of change in
income on the basis of family budget data (also called cross section data).
The next concept is that of the demand function. The functional relationship between demand
for a commodity and the factors that are responsible for the changes in its demand is known
as the demand function of the given commodity.
On the other hand, by supply of a commodity we mean the amount of a commodity, which is
available at a given price. The quantity supplied further depends on quantity produced which
in turn depends on a number of factors such as production costs, interest changes, cost of raw
materials, etc.
Let us now distinguish between those who demand a particular commodity and those who
supply it. In case of final goods and services like tea, coffee, biscuits etc., the household
demanded them and firms supply them. In case of services that are required for production,
the firms demand them and households supply them.
Law of demand
According to traditional law of demand, the demand for a commodity varies inversely with
its price, keeping the other factors constant. “other factors” refer to the prices of related
commodities, income, and tastes etc. A.A. Cournot first of all gave the mathematical
formulation of this law. According to this law, the demand ‘d’ is a continuous function of
price ‘p’ i.e. d = g(p), where g(p) is a decreasing function of ‘p’ i.e. g/(p) < 0 ∀ p > 0. Thus
the demand for a commodity increases with a fall in its price and decreases with a rise in its
price. However, there are certain exceptions to this law. In case of Geffen goods/ inferior
goods (named after R. Giffen), their demand increases with a rise in price and falls with a fall
in price. The curve obtained on plotting ‘d’ against ‘p’ is called the demand curve. Each point
on the curve tells us how much consumers are willing to buy for each price per unit that they
must pay...
Fig. 1: Demand curve
2
Demand curve is downward sloping. It is because as the price of the commodity falls its
demand rises and vice virsa. A lower price encourages the consumers to buy larger quantities
of the commodity than what they have been buying already. It also invites new buyers (as
ones who could not afford it earlier).
Law of supply
The law states that the supply varies in the same direction as that of price, keeping other
factors constants. “Other factors” refer to technological changes, costs of raw materials,
interest charges etc. According to A. A. Cournot, supply ‘S’ is also a continuous function of
price ‘p’ i.e. S = ψ(p) where ψ(p) is an increasing function of ‘p’ i.e. ψ ′( p ) > 0∀p > 0 . Thus
the quantity supplied of a commodity increases with an increase in its price.
Fig. 2: Supply curve
The curve obtained on plotting ‘S’ against ‘p’ is called the supply curve. Each point on the
curve tells us how much the producers are willing to supply for each price that they receive in
the market. Supply curve is upward slopping. It is because a higher price encourages the
producers to produce more. It also invites new producers to enter the market.
NOTE 1: Some Economists take price on the Y-axis and quantity demanded/ supplied on the
X-axis. They thus take d/S as independent variables and price as dependent variable. As
function ‘g’ and ‘ψ’ are invertible, we can write: p = g −1 (d ) and p = ψ −1 ( S ). However, in
this case we fix a certain amount of the commodity in the market and look for the highest
price at which the market will be cleared or lowest price at which there would be no shortage.
In a competitive market, the market price settles at the equilibrium price (or market-clearing),
which is the point of interaction of the two curves. At this point the quantity demanded is
exactly equal to the quantity supplied so that there is neither shortage nor surplus supply. To
understand how the market price settles at the equilibrium point φ, consider the following
figure:
3
Price
Fig. 3
Let ‘E’ be the point of interaction of the demand curve and the supply curve. Then ‘P0’ is the
equilibrium price and ‘Q0’ is the equilibrium quantity. Suppose the price were above the
equilibrium price, say at ‘P1’. At this point producers would try to produce and sell more than
what consumers are willing to buy. Obviously there would be excess supply that will create
competition among the producers and lower the price. In turn, demand would increase and
supply would decrease until the equilibrium price ‘P0’ is reached. On the other hand, if the
price were below ‘P0’ say at ‘P2’. At this point a shortage would develop as consumers
would not be able to purchase everything they would want at this price. This will create a
competition among the buyers and push the price up. Again, the price would settle at ‘P0’.
NOTE 2: It is only in a competitive market (where individual buyers and sellers have little
ability to influence the market price) that demand and supply curves determine the
equilibrium price. However, competitive markets are rarely found. But the markets for
agricultural commodities like wheat are assumed to exhibit the conditions of pure
competition. This is so because there are many producers of the same commodity and so all
producers must charge the same price. Thus each individual producer is very small in
comparison to the entire market and cannot influence the market price and so in a competitive
market, each producer is simply a price taker.
NOTE 3: A change in the prices of related commodities or change in income or a change in
tastes and habits of consumers may cause a rightward shift or leftward shift in the demand
curve. Similarly, a change in technology, capital cost and the prices of raw materials may
cause a shift in the supply curve.
Price elasticity of demand…
Changes in the prices of different commodities affect their demand in different degrees.
Suppose, the prices of tea and coffee rise, then their demand will fall but supply will increase.
However, this statement does not tell us anything about the amount of change in the demand
for tea and coffee that would result from a change in their price. Thus to know the sensitivity
of demand to the changes in price, Marshall gave the concept of ‘Price elasticity of demand’.
4
It may be defined as the ratio of relative change in demand to the relative change in price.
Further, suppose that the price of tea rises by 10% and that of coffee by 5%, then we would
like to know, how much will their demand change. The concept of elasticity was desired to
answer all such queries.
Let ‘y’ be the quantity demanded of a commodity with the demand function
y = g(p). Further, let ∂y represent an increment in demand ‘y’ corresponding to an increment
∂p in price. Then price elasticity of demand η p is defined as:
ηp =
∂y y p ∂y
=
∂p p y ∂p
Taking the limit as δp→0, price electricity of demand at a particular price ‘p’ is given as:
p ∂y p
∂y
= lim
∂p →0 y ∂p
y ∂p→0 ∂p
p dy
p dg d (log g)
===y dp g(p) dp d (log p)
ηp = lim
(1)
negative sign is taken since demand and price are inversely related.
Thus, elasticity of demand is a pure positive number independent of the units in which
demand and price are measured. It implies that with a 1% rise/fall in the price of a
commodity there will be η p % fall/rise in its demand. To understand things in a better manner
consider an example: suppose a particular household is using 500 gms. of tea per month when
tea is being sold at the rate of Rs. 80 per kg. Due to certain reasons the price of the tea rises to
Rs. 90 per kg, the household’s demand fall to 400 gms per month. Now the percent change in
−1
⎛ 400 − 500 ⎞
the quantity demanded is = ⎜
⎟ × 100 = × 100 = −20 and percent change in price is
5
⎝ 500 ⎠
100 50 25
⎛ 90 − 80 ⎞
=⎜
=
=
= 12.5 . Hence price elasticity of demand is
⎟ × 100 =
8
4
2
⎝ 80 ⎠
20
40 8
=
×2 =
= = 1.6
25
25 5
This implies that one percent increase in the price of tea results in 1.6 percent fall in the
demand.
The price elasticity of demand generally changes as we move along the demand curve,
therefore, it should be measured at a particular point on that curve.
Demand is said to be elastic if ηp >1 i.e. the percentage increase or decrease in quantity
demands exceeds the percentage decrease or increase in price. Thus higher the value of price
elasticity, greater is the degree of responsiveness of quantity demanded to price e.g. the
demand for buying a bigger car can easily be dispensed away with owing to a rise in its price.
Similarly, if the price of coffee goes up, one can easily switch over to tea. Demand for goods
5
having several uses, substitutes, luxuries is elastic. On the other hand if ηp <1 , demand is said
to be inelastic. In this case the percentage increase or decrease in quantity demanded is less
then the percentage decrease or increase in price. Demand for necessities or conventional
necessities (like tea) is inelastic.
Demand is said to be of unitary elasticity if quantity demanded does not change with an
increase or decrease in price.
Apart from the cases discussed above, there are two extreme cases:
1 When demand is completely inelastic.
In this case, consumers will buy a fixed quantity of the commodity, whatever its price may
be, so the elasticity of demand will be zero. For example, a patient of heart disease must take
the preventive medicine whatever be the price since it is essential for him. Figure 4 shows the
demand curve that is perfectly inelastic.
Fig. 4
2 When demand is infinitely elastic
In this case, consumers will buy the product at a fixed price only. A slight variation in price
will push the demand to either zero level or infinite (increase without limit). Elasticity of
demand, in this case will be infinity. The demand curve of infinity elasticity (perfect
elasticity) is given in Fig. 5.
Fig. 5
NOTE 4:
In case of related commodities, we talk of Partial Elasticities of Demand.
Consider two related commodities C1 and C2 with prices p1 and p2 per unit of x1 units of C1
and x2 units of C2 respectively. Let the corresponding demand function be written as:
6
x1 = g1(p1,p2);
x2 = g2(p1,p2)
(2)
Now, when the demand for commodity C1 is affected by a change in the price of C2, we talk
of Cross-Price Elasticity of Demand. It may be defined as: 1% increase in the price of one
good results in percent change in the quantity demanded of another good. Symbolically, it
may be written as:
∂
( log x1 )
∂x1 p 2
∂x1
.
η12 = −
=−
(3)
∂
x1 ∂p 2
( log p2 )
∂x1
which is the partial elasticity of demand for C1 with respect to p2 with p1 held constant.
Similarly, partial elasticity of demand for C2 with respect to p1 with p2 held constant can be
written as:
∂
( log x 2 )
∂x 2 p1
∂x 2
.
η21 = −
=−
(4)
∂
x 2 ∂p1
( log p1 )
∂x 2
In case of substitutes, e.g. tea and coffee, the cross-price elasticity will be positive. These
goods compete with one another in the market and a rise in the price of one good results in an
increase in demand of another. In case of complementary goods, which tend to be used
together, an increase in the price of one good results in a decrease in the consumption of
another. Thus, the cross-price elasticity of one good with respect to other will be negative in
this case. We can also define partial elasticity of demand for C1 with respect to p1 with p2
held constant as:
∂
( log x1 )
∂x1 p1
∂x1
.
η11 = −
=−
∂
x1 ∂p1
( log p1 )
∂x1
(5)
which is called Direct Partial Elasticity of Demand. Similarly, direct partial elasticity of
demand for C2 with respect to p2 with p1 held constant as:
η22
∂
( log x 2 )
∂x 2 p 2
∂x 2
.
=−
=−
∂
x 2 ∂p 2
( log p2 )
∂x 2
(6)
7
NOTE 5: An increase in the price of a substituted good causes an increase in demand and
hence rightward shifts of the demand curve, whereas an increase in the price of a
complementary good causes a leftward shift in the demand curve.
NOTE 6: As income increases the demand for normal goods increases and causes a
rightward shift in the demand curve, while that of inferior goods decreases causing a leftward
shift in the demand curve.
NOTE 7: When two demand curves interact, the elasticity associated with the flatter demand
curve is greater.
We can similarly define the concept of price elasticity of supply. It measures the degree of
responsiveness of quantity supplied to changes in price. Let εp denote the price elasticity of
supply, then
% change in the quantity supplied
εp =
% change in the price
=
∂S p p ∂S
× = .
(where S = ψ(p) is the supply function)
S ∂p S ∂p
(7)
At a particular price p, εp is given as:
⎛ p ∂S ⎞
p
⎛ ∂S ⎞
ε p = lim ⎜
⎟ = lim ⎜ ⎟
δ p→0 ⎝ S ∂p ⎠ S δ p→0 ⎝ ∂p ⎠
(8)
p dS d log S
=
=
S dp d log p
Elasticity of supply is generally positive as a rise in price gives producers an incentive to
produce more.
Demand curve of constant elasticity
Let ηp = a (say)
⇒
dg p
. = −a
dp g
⇔
dg
dp
= −a
g
p
(where d = g(p))
(9)
Integrating both sides we get:
log g = -alog p+log c (log c is the constant of integration)
(10)
8
( )
log g = log cp -a
⇒
d = g(p) = cp-a ; a>0, c>0
(11)
or else if we are given d = g(p) = cp -a ; a>0, c>0
then
g′(p) = −cap − a −1
⇒ ηp = −
(
)
p dg
p
= − −cap − a −1 = a
g dp
g
(12)
i.e. the curve given in (11) has constant elasticity at all points on the curve and resembles the
equation of a hyperbola.
In particular, if we take a = 1 we have from (11);
d = cp −1
⇒
d
=c
p
(13)
i.e. in case of unitary elasticity, demand curve takes the form of a rectangular hyperbola. The
curve extends towards both the axis uniformly without touching them.
NOTE 8: (10) shows that the curve of constant elasticity of demand when plotted on a
double logarithmic scale is a straight line.
Estimation of demand curves
The best way to estimate a demand curve is through techniques involved in regression
analysis. However, the data used for estimating the demand curve is obtained either from
market statistics or family budget enquiry. Some of the assumptions of the linear regression
model may not be satisfied by this data. Thus the least square estimate so obtained may not
possess certain desirable properties. In such a case, one can try out different forms of the
regression equations and choose the one which fits best into the observed data. Further,
demand for a commodity is influenced by a number of variables such as price, price of
related commodities, income, time etc. For estimating the demand curve theoretically, we
assume demand to be an explicit function of price keeping other factors constant. However,
in practice, these factors also vary with time. Thus to determine the demand curve the effect
of these factors on demand and price should either be eliminated or they should be treated
explicitly. Hence for estimating the demand function one should examine the form of the
demand relationship along with the nature of the data at our disposal. We discuss below the
type of data used for estimating the demand curve.
9
Family budget Data…
1.
2.
3.
In this method, we select a group of families homogenous with respect to
geographical area, economic and social factors, family size and all other factors
affecting demand.
We now allocate the households to different income levels at random. This eliminates
the effect of other factors but for income.
Information is now collected on expenditure incurred by different households on
various budget items for the period under study.
In this method expenditure rather than income is interpreted in terms of demand function.
Market Statistics or Time Series Data…
Market statistics refer to prices of various commodities and their quantities bought or sold at
that price at various points of time. Demand function using market statistics is determined by
taking demand as a function of price and not income. It is a well known fact that market price
at any point of time is the equilibrium price determined by the point of intersection of the
demand curve and supply curve. A change in the market price implies a shift in either or both
the demand and supply curves. When both the demand and supply curves shift, the market
data when plotted on the graph will give us a picture of variation of demand and supply
curves as a result of variation in the equilibrium price. In this case, it will not be possible to
trace either of the curves. If both the curves remain fixed, the market data does not provide
enough points for their determination. However, if one of the curves remains fixed and the
other changes its position, the market data gives enough number of points on the fixed curve
and hence determines it. Thus for the determination of the demand curve, it has to be
assumed as fixed while the supply curve shifts its position over time. We also assume that
demand curve is of constant elasticity and demand function is of the form:
d = α 0 +α1x1 +α 2 x 2 +......+α n x n
or
d = α 0 x1α1 x α2 2 ........x αn n
(14)
where α′i s are constant and xi’s are the prices of related commodities..
We shall now discuss the determination of the demand curve on the basis of family budget
data.
1 Pigon’s Method
This method is based on theory of utility.
Consider a group of individuals who have been classified according to their income. Let I1
and I2 be two adjacent income groups. Further, let U1(x) and U2(x) be the marginal degree of
utility functions on consuming x units of a given commodity for I1 and I2. Pigon’s made
following assumptions:
1.
Functions U1 and U2 are independent of the quantities of other commodities and of the
degree of utility of money.
2.
Tastes and habits of people in the two income groups are almost the same.
10
3.
Price elasticity of demand curve with respect to consumption x is equal to the
elasticity of the utility curve with respect to x i.e. utility of a good determines its
demand.
Let φ1 and φ2 denotes the degree of utility of money to I1 and I2 respectively. Then
U (x )
U (x )
φ1 = 1 1 , φ2 = 2 2
(15)
p
p
where x1, x 2 are the equilibrium quantities of a commodity C1 under consideration and p is
the corresponding price.
Now U1 (x) = U 2 (x) = U(x) [using assumption 2]
(16)
From (15) and (16) we have:
p=
U(x1 ) U(x 2 )
=
φ1
φ2
(17)
Consider
U(x 2 ) = U[x1 + (x 2 − x1 )]
U(x 2 ) = U(x1 ) + (x 2 − x1 )U′(x1 )
⇒ U′(x1 ) =
U′(x1 ) =
[using Taylor's expansion]
U(x 2 ) − U(x1 )
(x 2 − x1 )
(18)
p[φ2 − φ1 ] ⎛ φ2 − φ1 ⎞ U(x1 )
=⎜
⎟
(x 2 − x1 ) ⎝ φ1 ⎠ (x 2 − x1 )
(using 17)
Now elasticity of demand with respect to utility on consuming x1 units of a commodity is
given as:
ηx1 ,u =
Proportion change in demand
Proportion change in Utility
dx1 x1
U(x1 )
1
=
.
d
d[U(x1 )] U(x1 )
x1
[U(x1 )]
dx1
ηx1 ,u =
U(x1 )
1
×
x1
U′(x1 )
(19)
11
⇒ ηx1 ,u =
ηx1 ,u =
U(x1 )
d1
x −x
×
× 2 1
x1
(φ2 − φ1 ) U(x1 )
(from 18)
x 2 − x1
φ1
.
x1
φ2 − φ1
(20)
Now price elasticity of demand for the given commodity in the lowest income group when x1
units of it are consumed is given as:
dx
p
(21)
ηx1 ,p = 1 ×
dp x1
U(x1 )
φ1
dp
1
⇒
= U′(x1 )
dx1 φ1
from (17) we have p =
Thus
ηx1 ,p =
φ1
U(x1 )
p
.
=
= ηx ,u
1
x1 U′(X1 ) x1U(x1 )
(using 19) (22)
Consider another commodity C2. Let y1 and y2 be the equilibrium quantities of C2 being used
in I1 and I2 respectively. Then
ηy1 ,p =
y 2 − y1
φ1
.
y1
φ2 − φ1
(23)
Dividing (22) by (23) we get:-
ηx1 ,p
ηy1 ,p
=
x 2 − x1
y1
×
x1
y 2 − y1
(24)
⎡x − x
y1 ⎤
⇒ ηx1 ,p = ⎢ 2 1 ×
⎥ ηy ,p
y 2 − y1 ⎦ 1
⎣ x1
(25)
Now, if one of the elasticity is given, the other can be obtained from (25). Equations similar
to (22) can be obtained for the other income groups also to find corresponding elasticities of
demand.
NOTE 9: Pigon’s method simply gives us the ratios of elasticities of demand of two
commodities. To find the actual value of the elasticity of demand of a particular commodity,
we need to find the elasticity of demand of the other commodity of some other method.
12
2 Engel’s Curves
Ernest Engel, a German statistician made a detailed study of the family budget expenditures
of a number of families and propounded a law (1895) known as Engel’s law. The law states,
“The proportion of expenditure on food decreases as household expenditure increases”.
The graphic representation of the relation between household income and its expenditure on a
particular item of consumption is known as Engel’s curve.
Demand of a commodity depends on its price and the income of the household i.e.
d = g(µ,p).
(26)
where, d, is the demand for a commodity; p its price and µ the national income.
If we take price as fixed constant then d become a function of income only i.e.
d = g(µ,p/) = g1(µ)
(27)
The graphs obtained in this case are called Engel’s curves for constant prices.
Similarly if we take income as fixed then d become a function of p only i.e.
d = g(µ/,p) = g2(p)
(28)
The graphs obtained in this case are called Engel’s curves for constant income.
Engel’s curves for constant prices can be drawn in the following two ways. Here house hold
expenditure rather than income is taken as explanatory variable:1
Here we compare the budget of the same family at different points of time and see its
consumption pattern on different items as a consequence of variation in its income.
However, the assumption of a constant price at different points of time is not a
feasible assumption. Thus this method should only be used when the prices of the
given commodity and its related commodities remain more or less stable during the
given period of observation.
2
Here we study the expenditure pattern of a number of families with different income
levels. It is assumed that all individuals belonging to different families have identical
consumption habits, an assumption which is far from reality. To overcome this
drawback, we should stratify the families so that each stratum is homogenous with
respect to regional, environmental, social and occupational characteristics and should
be studied separately.
Estimation of the demand curve from market statistics
1
Pigon’s Method: Pigon made the following assumptions
1
Demand curve is a curve of constant elasticity for each interval of time i.e.
d = cp − a , c>0, a>0
(29)
taking log of both the side we have
13
log d = log c - a log p
⇔ Y = αX + β
(30)
where, α = -a, β = log c, Y = log d, X = log p
2
In successive interval of time, the rate of shift in the demand curve is the
same, i.e. if we consider the ith, (i+1)th and (i+2)th position then the distance between ith and
(i+1)th position is same as the distance between (i+1)th and (i+2)th position. Working in terms
of the logarithms we have from (30)
Yi = α Xi + β + (i − 1)γ
(i=1,2.......)
Yi +1 = α Xi +1 + β + iγ
(31)
Yi + 2 = α Xi + 2 + β + (i + 1)γ
so that
(Yi +1 − Yi ) − α (Xi +1 − Xi ) = (Yi+ 2 − Yi+1 ) − α (Xi+ 2 − Xi+1 )
⇒ (Yi + 2 − Yi +1 ) − (Yi +1 − Yi ) = α (Xi +1 − Xi ) − α (Xi+ 2 − Xi+1 )
Yi + 2 − 2Yi +1 − Yi = α (−2Xi +1 + Xi+ 2 + Xi )
⇒ αˆ =
Yi + 2 − 2Yi +1 − Yi
,
−2X i +1 + X i + 2 + Xi
i=1,2,....
(32)
Now calculate the value of α for each i from (32) after calculating the value of Xi’s and Yi’s.
Only the negative values of α are to be taken as a measure of elasticity of demand as price
and demand are inversely related. If most of the αi’s are negative and do not differ
significantly from one another, their mean could be taken as an estimate of the elasticity of
demand.
Drawbacks:
1
Pigon’s method fails if the successive observations are almost collinear
2
In the estimation of the demand curve, Pigon has taken demand to be a function of
price and time only, keeping the influence of all the other factors such as prices of
related commodities income etc. constant. However, practically it is not possible to
freeze the impact of other factors influencing demand.
2
Leontief’s Method: The market data gives the value of the equilibrium price at
different points of time. The equilibrium price of a commodity keeps changing over time
which in turn implies that both demand and supply curves change their position from time to
time. Thus one must study the extent of shift of these curves over time. Leontief assumed
that:
1
Both demand and supply curves shift independently of each other.
2
Both the curve are of constant elasticity.
Let α1, α2 be the elasticities of demand and supply respectively, then the equations of the
demand and supply curves are given as:
14
Yt = α1X t + U t → demand curve, t=1,2,..,n
Yt = α 2 X t + Vt → supply curve
(33)
where
Yt =
log d
, X t = log p
log s
(34)
Further, Ut and Vt are distributed independently of each other such that
E(U t ) = E(Vt ) = 0
(35)
Rewriting the above equations we get:
Yt − α1X t = U t
(36)
Yt − α 2 X t = Vt
Now multiplying them we get:
Yt2 + α1α 2 X 2t − (α1 + α 2 )X t Yt = U t Vt
(37)
Summing both the sides over t we have:
∑ Yt2 + α1α 2 X 2t − (α1 + α 2 )∑ X t Yt = ∑ U t Vt
(38)
Consider cov(Ut,Vt) = 0 (∵ Ut and Vt are distributed independently of each other)
⇒ E(U t , Vt ) − E(U t )E(Vt ) = 0
(by defination)
⇒ E(U t , Vt ) = 0 (∵ of 35)
(39)
Thus we have from (38)
∑ Yt2 + α1α 2 X 2t − (α1 + α 2 )∑ X t Yt = 0
(40)
As (40) is a function of two variables viz. α1 and α2 , to solve it, we divide the time range
t:[1,n] into two equal halves as:
⎡ n⎤
⎡n
⎤
⎢⎣1, 2 ⎥⎦ and ⎢⎣ 2 + 1, n ⎥⎦
We thus have
15
n 2
∑
t =1
Yt2
n
∑n
n 2
+ α1α 2 ∑
t =1
Yt2 + α1α 2
t = +1
2
X 2t
n 2
− (α1 + α 2 )∑ X t Yt = 0
t =1
n
∑n
X 2t − (α1 + α 2 )
t = +1
2
After calculating the values of
n
∑n
X t Yt = 0
(41)
t = +1
2
∑ Yt2 , ∑ X t Yt , ∑ X 2t from
the data, the above set of
equation can be solved simultaneously for α1 and α2.
Drawbacks:
1
Leontief’s assumption that both demand and supply curves can shift independently of
each other in any direction is not feasible.
There is no way of assuming that the elasticity of demand and supply are constant.
2
Leontief’s assumption that demand and supply curves shift simultaneously is also
3
questionable.
Forms of the demand functions
Let U = f(x1,x2,….,xn)
(42)
Denote the total utility function, where x1,x2,….,xn are the quantities of goods X1, X2,….., Xn
consumed at any point of time.
Let pi be the price of ith commodity and Y0 be the money income which is to be spent on Xi’s.
Then the budget equation can be written as:
Y0 = p1x1 + p 2 x 2 + ....... + p n x n
(43)
Now at the consumer’s equilibrium. The difference between total utility in terms of money
and the total expenditure on a commodity is maximised. It is attained when marginal utility
(in terms of money) is equal to price of the commodity.
Thus using Lagrange’s Multiplier’s, for consumer’s equilibrium, we have to maximise:
Z = u − λ[ ∑ pi x i − y 0 ]
(44)
where λ is Lagrange’s Multiplier. Using the principle of maxima and minima we have:
∂Z
=0
∂x i
⇒
∂u
− λ pi − 0
∂x i
⇒ λ=
1 ∂u
;
pi ∂x i
(45)
i=1,2,....,n
16
Thus the condition for consumer’s equilibrium is:
1 ∂u
1 ∂u
=
;
pi ∂x i p j ∂x j
(i ≠ j=1,2,....n)
(46)
Marginal utility of i th commodity Marginal utility of jth commodity
=
Price of i th commodity
Price of jth commodity
⇒
or equivalently.
There will be (n-1) such equations which along with the budget equations (43) can be solved
under ordinary conditions for xi’s (i =1,2,…,n) in terms of price pi’s and income Y0 . Hence
the marginal utility together with the budget equation (43) will enable us to equation (46)
obtain the demand function.
The solution so detained give a maxima of Z and hence u.
Income elasticity of demand
Demand for any commodity depends on its price, price of the related commodities, household
income etc. Thus its demand function can be written as:
d = g(µ, p, p1,…pn)
(47)
where µ is the household income, p is the price of the commodity, pi is the price of the ith
related commodity, i = 1,…,n.
Then income elasticity of demand at income ‘µ’ is defined as:
ηµ =
µ ∂g ∂ log g
=
g ∂µ ∂ log µ
(48)
we take the positive sign as income and demand are directly related.
Interpretation: It shows that 1% increase (decrease) in income will result in ηµ % increase
(decrease) in demand.
EXAMPLES
EXAMPLE 1
Let Yc1 and Yc2 be the demand functions of two commodities c1 and c2 define
respectively as:
Yc1 = 25 – 3pc1 – pc2
(a)
17
Yc2 = 21 – pc1 – 2pc2
(b)
Similarly, Let Sc1 and Sc2 be the supply functions of two commodities c1 and c2 define
respectively as:
Sc1 = -16 + pc1 + 2pc2
(c)
Sc2 = -8 + pc1 + pc2
(d)
where pc1 and pc2 be the price of the commodities c1 and c2 respectively, then compute:
1)
the equilibrium prices
2)
the equilibrium quantities
SOLUTION
Under equilibrium situation Yc1 = Sc1 & Yc2 = Sc2.
Thus from (a) and (c) we get
25 – 3pc1 – pc2 = -16 + pc1 + 2pc2
and from (b) and (d) we get
21 – pc1 – 2pc2 = -8 + pc1 + pc2
(e)
(f)
Solving (e) and (f) we get pc1 = 5 and pc2 = 7
i.e. the equilibrium price for the commodity c1 is 5 and for c2 is 7.
Substituting in equation (a) and (b) we get
Yc1 = Sc1 = 3 & Yc2 = Sc2 = 2.
EXAMPLE 2
Let p 0.6 p 0.3 and p1.6 p 0.8 be two demand functions for commodity c1 and c2 respectively.
c1 c2
c1 c2
Comments whether the commodities c1 and c2 are competitive or complementary.
SOLUTION
Consider the first demand function Y = p 0.6 p 0.3 then
c1
c1 c2
∂Yc1
0.3p 0.6
−0.7
c1
= 0.3p0.6
p
=
>0
c1 c2
∂pc2
p0.7
c2
(a)
Similarly consider the second demand function Y = p1.6 p 0.8 then,
c2
c1 c2
∂Yc2 0.3p0.6
= 0.7c1 > 0
∂pc1
pc2
(b)
Since both (a) and (b) are positive, the commodities c1 and c2 are competitive.
EXAMPLE - 3
For the example 2, compute partial elasticities of demand.
SOLUTION
For the first demand function the partial elasticities are:
18
ηc11 =
− p c1 ∂Yc1
−p
−.4 .3
.
= .6 c1.3 .6p c1
p c2 = −.6
Yc1 ∂p c1 p c1p c2
ηc12 =
− p c2 ∂Yc1 − p c2
−.7
.
=
.3p.6c1p c2
= −.3
Yc1 ∂p c2 p.6c1p.3c2
Similarly, for the second demand function the partial elasticities are:
− p ∂Y
−p
ηc21 = c1 . c2 = 1.6 c1.8 1.6p.6c1p.8c2 = −1.6
Yc2 ∂p c1 p c1 p c2
− p c2 ∂Yc2
−p
−.2
.
= 1.6 c2.8 .8p1.6
c1 p c2 = −.8
Yc2 ∂p c2 p c1 p c2
ηc22 =
EXAMPLE - 4
Let the demand function for a commodity c is given by:
Y = 100 − .4p c2 + .01p 0 + .03I
where Y is the quantity demand for a commodity c, pc is the price of the commodity c, p 0 is
the price of a related commodity and I is the constant income. Calculate
a)
the price elasticity of demand
b)
the income elasticity of demand
c)
cross elasticity of demand
SOLUTION
ηp = −
c
a)
=−
=.8
ηI = −
b)
=
p c ∂Y
Y ∂pc
pc
∂
(100 − .4pc2 + .01p0 + .03I)
100 − .4p + .01p 0 + .03I ∂pc
2
c
pc2
100 − .4pc2 + .01p0 + .03I
I ∂Y
Y ∂I
I
∂
(100 − .4pc2 + .01p 0 + .03I)
100 − .4p + .01p 0 + .03I ∂I
=.03
2
c
I
100 − .4p + .01p0 + .03I
2
c
19
ηp = −
0
=
c)
p 0 ∂Y
Y ∂p0
p0
∂
(100 − .4pc2 + .01p0 + .03I)
100 − .4p + .01p0 + .03I ∂p 0
=.01
2
c
p0
100 − .4p + .01p0 + .03I
2
c
EXAMPLE 5
Let Y = −6p 2 − 3p + 2I + 6I 2 is the demand function, where Y is quantity demanded, I (>0) is
the income and p (>0) is the price. Compute
a)
the slope of the demand curve
b)
is the commodity normal or inferior?
SOLUTION
a)
The slope of the demand curve:
∂Y ∂
= (−6p 2 − 3p + 2I + 6I 2 )
ηp =
∂p ∂p
= − 12p − 3
b)
The commodity will be normal if η I =
Now
ηI =
∂Y
>0
∂I
∂Y ∂
= (−6p 2 − 3p + 2I + 6I 2 )
∂I ∂I
=2 + 12I > 0
Thus the commodity is normal.
EXAMPLE - 6
The following table gives the yearly per capital consumption (dt) of rice in kgs. and the real
price (pt) for the year (t) 1982 to 2006. Fit a demand curve of the form
d t = cp −t α
t
dt
pt
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
26.02 27.03 28.80 30.22 31.97 32.83 33.49 36.47 37.71 38.61 39.46 40.34
2.19 1.85 2.01 1.98 1.90 1.72 1.68 1.64 1.56 1.48 1.43 1.38
t
dt
pt
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
40.17 40.90 42.61 43.61 43.74 43.23 43.74 44.16 44.75 44.99 45.12 45.34 45.58
1.45 1.60 1.53 1.48 1.62 1.66 1.69 1.89 2.01 2.34 2.68 2.89 3.02
SOLUTION
Consider the demand curve d t = cp −t α . Taking log on both the sides we get:
20
log d t = log c - α log p t
By the principal of least square we get:
∑ log d t = n log c - α ∑ log pt
t
(a)
t
∑ (log p ). (log d ) = log c ∑ log p - α ∑ (log p )
t
t
t
t
t
t
2
(b)
t
For computing the values of c and α we consider the following table:
t
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
TOTAL
dt
26.02
27.03
28.80
30.22
31.97
32.83
33.49
36.47
37.71
38.61
39.46
40.34
40.17
40.90
42.61
43.61
43.74
43.23
43.74
44.16
44.75
44.99
45.12
45.34
45.58
pt
2.19
1.85
2.01
1.98
1.90
1.72
1.68
1.64
1.56
1.48
1.43
1.38
1.45
1.60
1.53
1.48
1.62
1.66
1.69
1.89
2.01
2.34
2.68
2.89
3.02
log (dt)
1.4153
1.4318
1.4595
1.4802
1.5048
1.5162
1.5249
1.5619
1.5764
1.5867
1.5962
1.6057
1.6039
1.6117
1.6295
1.6396
1.6409
1.6358
1.6409
1.6450
1.6508
1.6531
1.6544
1.6565
1.6588
39.5804
log (pt)
0.3402
0.2664
0.3024
0.2975
0.2796
0.2359
0.2242
0.2153
0.1936
0.1708
0.1538
0.1397
0.1607
0.2030
0.1840
0.1708
0.2092
0.2213
0.2272
0.2765
0.3032
0.3692
0.4281
0.4609
0.4800
6.5136
log (dt)*log
(pt)
log(pt)*log(pt)
0.4815
0.1157
0.3815
0.0710
0.4414
0.0915
0.4403
0.0885
0.4208
0.0782
0.3577
0.0556
0.3419
0.0503
0.3362
0.0463
0.3052
0.0375
0.2711
0.0292
0.2455
0.0237
0.2243
0.0195
0.2578
0.0258
0.3272
0.0412
0.2998
0.0339
0.2801
0.0292
0.3433
0.0438
0.3619
0.0490
0.3728
0.0516
0.4548
0.0764
0.5005
0.0919
0.6104
0.1363
0.7083
0.1833
0.7635
0.2124
0.7962
0.2304
10.3239
1.9122
Substituting the values in (a) and (b) we get
39.5804 = 25* log c - α * 6.5136
10.3239 = log c * 6.5136 - α *1.9122
on solving (d) and (e) we get c = 39.54 and α = 0.053154
The price elasticity of demand is: ηp = α = 0.053154
(d)
(e)
21
PRACTICE PROBLEMS
QUESTION - 1
Let Yc1 and Yc2 be the demand functions of two commodities c1 and c2 define respectively
as:
Yc1 = 12 – 2pc1 – 2pc2
(a)
Yc2 = 20 – pc1 – 3pc2
(b)
Similarly, Let Sc1 and Sc2 be the supply functions of two commodities c1 and c2 define
respectively as:
Sc1 = -6 + 2pc1 + 3pc2
(c)
Sc2 = -8 + 4pc1 + 2pc2
(d)
where pc1 and pc2 be the price of the commodities c1 and c2 respectively, then compute:
1. the equilibrium prices
2. the equilibrium quantities
QUESTION – 2
Let p 0.4 p 0.2 and p 0.6 p1.8 be two demand functions for commodity c1 and c2 respectively.
c1 c2
c1 c2
Comments whether the commodities c1 and c2 are competitive or complementary. Also
compute partial elasticities of demand.
QUESTION -3
Let the demand function for a commodity c is given by:
Y = 100 − .4p c2 + .01p 0 + .03I
where Y is the quantity demand for a commodity c, pc is the price of the commodity c, p 0 is
the price of a related commodity and I is the constant income. Calculate
1. the price elasticity of demand
2. the income elasticity of demand
3. cross elasticity of demand
QUESTION - 4
Let Y = −6p 2 − 3p + 2I + 6I 2 is the demand function, where Y is quantity demanded, I (>0) is
the income and p (>0) is the price. Compute
1. the slope of the demand curve
2. is the commodity normal or inferior?
QUESTION - 5
The following table gives the yearly per capital consumption (dt) of rice in kgs. and the real
price (pt) for the year (t) 1980 to 2004. Fit a demand curve of the form
d t = cp −t α
22
T 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
d 4.423 4.595
5.137 5.434 5.581 5.693 6.199 6.410 6.563 6.708 6.857
4
1
4.896
4
9
1
3
9
7
7
2
8
t
0.240 0.235 0.229 0.218 0.207 0.200 0.193
0.281 0.277
p 0.306
0.266
0.259
8
2
6
4
2
2
2
4
2
6
t
t 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
7.243 7.413 7.435 7.349 7.435 7.507 7.607 7.648 7.670 7.707 7.748
d 6.828
6.953
7
7
8
1
8
2
5
3
4
8
6
9
t
0.214 0.207 0.226 0.232 0.236 0.264 0.281 0.327 0.375 0.404 0.422
p
0.203 0.224
2
2
8
4
6
6
4
6
2
6
8
t
References
1.
2.
3.
4.
Gupta S.C. and Kapoor V.K. (1987), Fundamental of Applied Statistics, Sultan Chand & Sons.
Goon, A.M. Gupta, M.K. & Dasgupta, B. (1986), Fundamentals of Statistics, Vol. 2, The World Press
Private Limited, Calcutta.
Johnston J. (1991), Econometric Methods, McGraw-Hill Book Company
Soni R.S. (1996) Business Mathematics with Applications in Business & Economics, Pitambar
Publishing Company (P) Ltd. New Delhi.
23